June 27, 2018 / 9:42 AM / a year ago

GRAPHIC -Viva Espana: Spain emerges as euro zone bond market's star

* Spain best-returning euro zone bond market so far of 2018

* Italian returns deep in negative territory

* Leaves stark divergence in southern Europe bond markets

* Euro zone bond returns year-to-date: reut.rs/2KjSTON

* Absolute change in bond yields: Yearly reut.rs/2MYK6DL

By Dhara Ranasinghe and Abhinav Ramnarayan

LONDON, June 27(Reuters) - Halfway through 2018, the divergence between southern Europe’s bond markets could not be any more stark — Spain has emerged as the euro zone’s best-performing major government bond market and Italy as the worst.

Often lumped together as the euro zone periphery, alongside Greece and Portugal, Spain this week displayed its popularity with investors in a 7 billion-euro, 10-year syndicated bond deal. Demand was over 24 billion euros when books closed on Tuesday.

Spanish 10-year bonds have delivered returns of almost 3 percent so far this year, according to Thomson Reuters data, highlighting resistance to contagion from Italy as well as political ructions following a change of government in early June.

Moody’s upgraded Spain’s ratings in April, the third upgrade for Spain this year. Faster economic growth, efforts to reduce debt and relatively high yields explain Spain’s outperformance against its southern European peers and the euro zone’s benchmark issuer Germany.

“Spain is doing what Belgium and Ireland did, which is essentially transition from a peripheral to a semi-core market based on less-risky politics, improving fundamentals, especially relative to the likes of Italy, and decent growth thanks to a reform effort over several years,” said Patrick O’Donnell, an investment manager at Aberdeen Asset Management.

Italy, on the other hand, is this year’s worst-performing major euro zone bond market so far, with 10-year bonds returning a negative 6.4 percent. If full-year returns are negative, that would break six straight years of positive returns on Italian debt.

The market had offered offering positive returns until mid-May. Since then, an anti-establishment coalition government with big spending plans has taken office, raising concern about Rome’s commitment to the euro.

“Italy is structurally problematic, and the divergence between Spain and Italy is because Spain was in a position to stimulate,” said Andrea Cicione, head of strategy at TS Lombard. “From a fiscal standpoint, it ran a 6 percent deficit and is starting to rein it in. Italy has no such levers.”

Meanwhile, Portuguese bonds, which in 2017 boasted some of the best returns in the euro zone, have returned 1.4 percent so far this year - around the same as higher-rated Germany.

The European Central Bank this month signaled it would keep interest rates low well into 2019 even as it winds up its massive bond-buying stimulus by year-end. That dovish guidance has underpinned bond markets.

Italy is the outlier. Yields on 10-year Spanish and Portuguese government bonds are down some 19 and 6 basis points respectively this year, but Italian yields are up some 90 bps.

“Bond investors are pretty nervous and that’s what been holding Italian bonds back,” said Said Haider, chief executive officer of macro hedge fund Haidar Capital Management.

Reporting by Dhara Ranasinghe and Abhinav Ramnarayan; graphics by Dhara Ranasinghe; editing by Larry King

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